The method of local increments is used in connection with an embedded cluster approach and wave function based quantum chemical ab initio methods to describe the adsorption of a single CO molecule on the MgO(001) surface. The first step in this approach is a conventional Hartree-Fock calculation. The occupied orbitals are then localized by means of the Foster-Boys localization procedure, and the full system is decomposed into several "subunits" that consist of the orbitals localized at the CO molecule and at the Mg and O atoms of the MgO cluster. The correlation energy is expanded into a series of local n-body increments that are evaluated separately and independently. In this way, big savings in computer time can be achieved because (a) the treatment of a large system is replaced with a series of much faster calculations for small subsystems and (b) the big basis sets necessary for describing dispersion effects are only needed for the atoms in the respective subsystem while all other atoms can be treated by medium size Hartree-Fock type basis sets. The coupled electron pair approach, CEPA, an approximate coupled cluster method, is used to calculate the correlation energies of the various subsystems. For the vertical adsorption of CO on top a Mg atom of the MgO (001) surface with the C atom toward Mg, the individual one- and two-body increments are calculated as functions of the CO-MgO separation and a full potential energy curve is constructed from them. A very shallow minimum with an adsorption energy of 0.016 eV at a Mg-C distance of 3.04 angstrom is found at the Hartree-Fock level, while inclusion of correlation (dispersion) effects shortens the Mg-C distance to 2.59 angstrom and yields a much larger adsorption energy of 0.124 eV. This is in very good agreement with the best experimental value of 0.14 eV. The basis set superposition error, BSSE, was fully corrected for by the counterpoise method and the bonding mechanism was analyzed at the Hartree-Fock level by means of the constrained space orbital variation, CSOV, analysis.